In the UK, share-based payments are already required to be expensed under UITF17. But whereas this expense is the difference between the underlying share price at grant date and the employee contribution (intrinsic value), IFRS2 requires share-based payments to be expensed at fair value.
This, alongside other differences to current UK practice, will mean a significant increase in the frequency and amount of expenses recorded for share-based payments in company accounts from 2005.
IFRS2 seeks to measure the fair value of services received from employees by reference to the fair value of a share option, multiplied by the number of options that ultimately vest. This measure will mean a greater hit on the accounts, as the fair value of an option will be recorded as higher than the intrinsic value of the share.
To understand this, compare two different employee packages, one comprising cash plus an option to acquire a share at today’s price in three years’ time, and one comprising ownership of the share itself.
In the first package you can earn interest on the cash for three years, although you don’t receive the generally small amount from dividends that you would in the second package. The major bonus of this package is the one-way nature of the share option.
In effect it is a free bet on whether the share price will be higher than today’s price in three years’ time. If you hold an actual share you suffer a loss if the price goes down. If you have an option, you don’t have to exercise it and suffer that loss – you still have the cash and subsequent interest. If the share price rises you gain with either package.
It is, however, complicated to determine the fair value of a share option at grant date because it involves predicting, among other things, future share price movements. But there are well-established and accessible mathematical techniques, for example the Black-Scholes and the binomial models, that are used by option traders to predict the future movements in share price and therefore to derive the fair value of an option.
Another significant difference from current practice is that IFRS2 will also apply to SAYE (save as you earn) schemes, which are currently exempt in the UK. Under IFRS, the discount at which SAYE shares are issued to employees will be an expense.
There is, however, a key question left unanswered by IFRS2. What is the treatment of own shares held by employee benefit trusts? In the UK, UITF38 now requires own shares held by employee benefit trusts to be deducted from shareholders’ funds.
IFRS is unclear on the subject, because employee benefit trusts appear to be specifically excluded from both SIC12 special purpose entities and IAS19 employee benefits. It seems entirely possible that own shares held by employee benefit trusts will come back on the balance sheet as assets under IFRS, having just been removed from it under UK GAAP. This subject is on the agenda of the IASB’s interpretative body, IFRIC.
The long-awaited arrival of IFRS2 is going to make the means of payment of bonuses largely neutral in profit and loss account terms between cash and shares or share options. But a significant increase in the amount of expense recorded for share-based payments is inevitable. We will, however, have to wait to find out about own shares held by employee benefit trusts.
Mark McMullen joins the private client services team from Smith & Williamson
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